Junk Loans Turned Into AAA Debt at Record Pace: Credit Markets

Jul 10, 2014 9:48 am ET

July 10 (Bloomberg) -- Deals packaging junk-rated corporate loans into securities with ratings as high as AAA are being done at a record pace, fueling a boom in the underlying debt that the Federal Reserve says is showing signs of froth.

Led by Leon Black’s Apollo Global Management LLC, $13.8 billion of collateralized loan obligations were raised in the U.S. last month, an all-time high, according to Morgan Stanley and data compiled by Bloomberg. Julian Black, a Cayman Islands- based lawyer who helped raise more than $25 billion in CLOs in 2013, predicts as much as $120 billion will be sold this year, a record.

“The market has been surprised by the volume,” Black, the global head of structured finance at Appleby Global Group Services Ltd., said in a telephone interview.

The flurry of CLOs underscores the length investors are going to in order to generate returns with the Fed forecast to hold interest rates near zero until at least mid-2015. As the biggest buyers of leveraged loans, CLOs are helping to make it easier for speculative-grade borrowers to obtain credit -- so much so that the Fed and the Office of the Comptroller of the Currency are worried about deteriorating underwriting standards.

Fed Concern

Some Fed policy makers said at their June meeting that they saw signs of increased risk-taking “as an indication that market participants were not factoring in sufficient uncertainty about the path of the economy and monetary policy,” minutes released yesterday showed, without specifically mentioning loans.

CLOs, which funded some of the largest leveraged buyouts in history, pool high-yield corporate loans and slice them into securities of varying risk and return, typically from AAA ratings down to B. The lowest portion, known as the equity tranche, offers the highest potential returns and the greatest risk because investors are the first to see their interest payouts reduced when loans backing the CLO default.

Yield spreads on the AAA portion of new CLOs were about 147 basis points more than the London interbank offered rate as of July 3, compared with 77 basis points for AAA commercial mortgage-backed securities, according to Wells Fargo & Co. Libor is the rate banks say they can borrow in dollars from each other. A basis point is 0.01 percentage point.

Volcker Rule

Sales in June were boosted by a $1.5 billion CLO raised by New York-based Apollo, the largest fund formed in the U.S. this year, Bloomberg data show. The deal includes a $930 million top- rated slice that pays a coupon of 143 basis points more than Libor.

Issuance has been on the rise after investment managers began structuring CLOs to comply with the Volcker Rule, a final draft of which was published in December. The regulation that’s part of the Dodd-Frank Act, which is aimed at curtailing risk- taking by banks, prohibits lenders from investing in the debt of CLOs that own bonds.

Banks hold about $70 billion of CLO debt, according to estimates by the Loan Syndications and Trading Association, a New York-based trade group. Sales fell to $2.55 billion in January, according to Royal Bank of Scotland Group Plc.

JPMorgan in May raised its 2014 issuance forecast to a range of $90 billion to $100 billion from $60 billion to $70 billion. Wells Fargo boosted its prediction last month to $100 billion from a range of $80 billion to $90 billion.

New Buyers

There has been a “real expansion of the CLO investor base beyond just banks,” Dave Preston, a CLO analyst at Wells Fargo in Charlotte, North Carolina, said in a telephone interview. “The historical performance of CLOs help get people more interested. If you look at the return compared to performance, people are happy to buy CLOs, especially at the AAA level.”

Out of 719 U.S. CLOs that purchased widely syndicated loans and were rated by Moody’s Investors Service between January 1996 and May 2012, only 14 lost any of their principal at maturity, according to a July 2012 report from the ratings firm.

“Compared to other asset classes, CLO debt and equity looks attractive,” Mike Rosenberg, a principal at Tetragon Financial Management LP in New York, which invests in the debt, said in a telephone interview.

The growth in CLOs, which according to the LSTA buy 58 percent of all leveraged loans, has helped propel issuance of the debt to $222.3 billion this year, up from $180.4 billion in same period of 2013, Bloomberg data show. A record $357.9 billion of new loans were issued last year.

Lax Underwriting

This boom in riskier lending led the Fed and the OCC to warn lenders last year to reign in lax underwriting practices. Todd Vermilyea, a Fed official, said in the transcript of a speech given May 13 in Charlotte, North Carolina, that standards “have continued to deteriorate in 2014” and that “stronger supervisory action” may be needed.

For the first time, more than half of all loans arranged this year are covenant light, meaning they lack typical lender projections such as a limit on the amount of debt a borrower can have compared to its earnings.

“The regulatory environment that banks are facing, where regulators are squeezing other products, means CLOs stand out at the moment,” Black of Appleby said.